A study of mortgage prepayment risk

Housing Finance International, Dec 2001 by Perry, Simon, Robinson, Stuart, Rowland, John

EXECUTIVE SUMMARY

As recently as five years ago, the average tenure of a residential mortgage in the United Kingdom was around seven years. Most lenders will tell you that the equivalent figure today is nearer four, due mainly to consumers' increased willingness to switch lender for a better deal. This is a worrying trend for lenders since, because of the high costs of acquiring a mortgage, mortgages typically need to remain on the books for several years in order to be profitable.

Fixed -rate loans, which account for around one-third of U.K. residential mortgages, typically have even shorter lives. They pose a particular problem for lenders, because of the financial impact of early repayment on their funding arrangements. Because of the significance of this problem, eight of the top ten lenders, representing over 65% of the nation's outstanding loans, participated in this six-month study, providing the necessary data for analysis.

The work undertaken explores both the causes and the results of prepayment of fixed-rate mortgages. The techniques employed shed new light on the reasons why customers repay ahead of schedule. They advance the industry's understanding of the circumstances in which prepayment is most and least likely.

Four drivers are shown to have a significant impact on prepayment behavior:

Age of the fixed-rate loan. From the point at which a borrower takes out a fixed-rate mortgage, it usually takes some time for a significant interest differential to appear. And after having gone through the process of applying for one mortgage, few borrowers immediately look to remortgage again. Prepayment rates generally rise in the second half of the fixedrate period, but tail off before the end of the period.

* House price inflation. When house price inflation is high, the number of home moves increases. Increased activity in the housing market results in increased prepayment.

Interest differential. This measures the tangible saving that a borrower could make by switching to another fixed-rate or variable-rate mortgage. A high interest differential encourages borrowers to prepay, but the effect of interest movements is far from linear.

* Prepayment charges. These charges create a cost to prepayment that acts as a disincentive to prepay. We observed that charges over a certain level appeared to discourage prepayment significantly.

These four factors interact with each other and with a number of other variables to determine the likelihood of early prepayment.

As well as exploring the causes of prepayment, this study considers the impact of prepayment on profitability and value creation and shows how techniques such as projection modeling, predictive modeling and stochastic modeling can be used to manage prepayment risks better. In doing so, it points towards ways of reducing prepayment risk through product design, pricing and customer retention initiatives.

1. INTRODUCTION

1.1 Background and Motivation

An investigation of mortgage prepayment risk in fixed-rate loans was chosen as the subject of this study after discussions with the banking community because the issue was of current interest to banks, due to:

Downward pressure on early prepayment charges.

* A move to flexible products with charge free withdrawals.

* Increased propensity of customers to remortgage.

Mortgages are similar in nature to many of the insurance products that are routinely modeled, as they are long-term products (typically 25 years) and typically have high up-front acquisition costs.

1.2 Intended Audience

In this study, we have analyzed the relationships between a number of potential drivers of prepayment behavior and developed models that predict prepayment behavior. Our analysis will be of interest to banking professionals with an interest in:

* The management of prepayment risk exposures.

The design and pricing of mortgage products.

The development of customer retention initiatives.

1.3 Scope of This Study

For the purposes of this study, we have defined prepayment risk to be the risk of loss to the lender due to early repayment by the borrower of all of a fixed-rate loan before the end of the fixed-rate period. The prepayments can occur under four circumstances:

Refinancing. A borrower may decide to move to a new mortgage that offers a better rate.

* Repayment A borrower may decide to repay the mortgage early using, for example, savings, a bonus or a windfall.

* Moving house. A borrower may terminate an existing mortgage when moving to a new property.

Default. A borrower who defaults on a mortgage has, in a sense, made a prepayment as the lender has to recover the funds and invest them elsewhere.

In this study we have focused on analyzing the behavior of borrowers who intentionally prepay their loans. We have, therefore, excluded borrowers who defaulted. Further, borrowers often choose to prepay part of their loan early. We have not analyzed partial prepayments in this study.

1.4 Overview of This Report

The remainder of this report is organized into the following sections: